Just Saving Isn't Enough: How Cash Flow Allocation Helps You Retire

You've probably heard the term "asset allocation" in discussions about retirement accounts and investing strategies. It's an important concept to understand and apply to your own finances. But don't be intimidated by the term or the complex definitions — the principle is a fairly simple one. (See also: The Basics of Asset Allocation)

At its heart, asset allocation is about reducing your risk by not putting all your eggs in one basket. And that's achieved by diversifying — or spreading out — the number and types of your investments.

Define "Assets," Please

OK, but what assets are we talking about, and what's the "cash flow" connection?

The assets typically associated with asset allocation are stocks, bonds, and cash equivalents such as money market funds. These are the ones commonly included in professionally managed mutual fund retirement accounts like a 401(k) or 403(b). So the thinking is, if you effectively diversify within and across each of these three asset categories, you will reduce your investment risk and achieve a balance that matches your risk tolerance.

And you will…at least among those assets.

But do these three assets alone make for a comprehensive retirement strategy? Nope.

For one thing, there are many other types of assets besides stocks, bonds, and cash that can — and should — contribute to your retirement plan. Which ones? Here's where the cash flow connection comes in. (See also: 6-Step Plan to Boost Your Retirement Savings Fast)

Will Your Assets Pay the Bills?

If you think about it, your mutual fund retirement account will generate only one income stream during your retirement. From a cash flow perspective this stock/bond/money market mix essentially represents only one egg. And as we now know, relying on only one source — in this case only one cash flow source — is a risky strategy. Better to allocate across multiple sources.

To see this more clearly let's step back and look at the bigger picture. A good place to start is with a definition of your ultimate retirement goal. The goal for most is financial independence, and that's measured by monthly income or cash flow. You will need enough non-salary monthly cash flow to pay your living expenses in retirement. The more — and the more diverse — your sources of cash flow, the more secure will be your retirement. (See also: 7 Truths for a Successful Retirement)

Your 401(k), 403(b), IRA, or mutual fund retirement account portfolio of stocks, bonds, and cash equivalents gives you a good start. After you stop working you can use these assets to generate monthly cash flow in a number of ways:

You can convert it to an annuity that pays you monthly for life.

You can convert it to a savings account or CD and draw down a certain percentage of the account balance on a regular basis until it's exhausted.

Or, if your cash flow needs are mostly met by other assets, you can keep the principal intact and just draw from the stock dividends and bond interest income.

Other Cash Flow Generating Assets

What other assets generate cash flow?

Company Pension

This usually takes the form of a monthly payment for life, but in some cases companies offer the option of a single lump sum payout. Your "lump sum to cash" conversion options are similar to those listed above for a traditional retirement account.

Rental Income From Real Estate

Unlike a company pension, you own this asset and can sell it at any time for a lump sum amount. But if it provides a steady stream of positive cash flow, you might want to keep it — for it's that rare asset that appreciates in value AND whose monthly income (from rents) can also grow to keep pace with inflation. (See also: Should You Become a Landlord?)

Business Income

Owning a rental property is essentially like owning a business. So owning all or part of a business provides similar options: sell your stake for a lump sum or retain an ownership interest that can provide a regular income stream (plus the added bonus of possible tax advantages).

Social Security

Like a company pension, you don't own this asset; your only choice is a guaranteed lifetime stream of monthly cash flow.

Plan Ahead to Create Multiple Cash Flow Streams

Some of these cash flow sources might not be available to you. Traditional company pensions, for example, are becoming a thing of the past. But all of the others are under your control, and it's not too late to include some in your retirement plans.

Seven Streams Into Our House

Our household's retirement goal, for example, is to include seven cash flow sources. My wife and I were fortunate enough to work for employers who offered traditional defined benefit pension programs. They will represent those sources of monthly income. We also have a 401(k) and IRA retirement account portfolio (#3), positive cash flow from a rental property (#4), two future Social Security payments (#s 5 and 6), and a business (#7).

Looking ahead, I'd also like to buy or share in the ownership of another rental property, which would raise our number to eight. So our goal, like yours, should be flexible and open to change. The important part is to set a goal — set your cash flow number — so you can start making plans to achieve it.

And remember — as you move ahead with your plans that having multiple cash flow-generating assets is preferable to relying on only one or two, because it diversifies or lessens your risk. You can more easily absorb the loss of one out of seven sources of retirement income than the loss of one out of two. So seek opportunities to earn or acquire multiple sources of positive cash flow.

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Great suggestions. Another reason to have a flexible cash flow is so you have reserves for Things That Go Wrong. For example, there's a good chance that you or a family member will have unexpected medical costs.